Buy Hold Sell: 6 high-conviction small caps

They say that it is an investor's best ideas that produce the best returns. 

It sounds simple, right? (Right?) And yet, investors and fund managers' portfolios consistently balloon out to 40, 50, or even 60 holdings or more, with diversification for downside protection often to blame. 

And while no one - and I mean no one - likes to see their portfolio in the red, Harvard Business School researchers Miguel Antón, Randolph Cohen, and Christopher Polk recently found that a portfolio of high-conviction holdings - AKA your best ideas - actually statistically outperforms. 

In fact, they found that active and hedge fund managers' top ideas outperform the market - as well as their other holdings - by approximately 2.8-4.5% per annum. Meantime, the vast majority of the other stocks these managers hold don't exhibit this significant outperformance. 

So - *drumroll please* - in this episode of Buy Hold Sell, Livewire's Ally Selby is joined by arguably the best Aussie small-cap managers in the country - Chris Stott from 1851 Capital and Marcus Burns from Spheria, for their analysis of their best three ideas. Plus, they'll share their thoughts on each other's top holdings too. 

Note: You can watch, read or listen to the discussion below. This episode was filmed on 27 May 2021.

Edited Transcript

Ally Selby: Hello, and welcome to Livewire's, Buy Hold Sell. I'm Ally Selby, and today I'm joined by Chris Stott from 1851 Capital and Marcus Burns from Spheria, where they'll be sharing their thesis behind their three highest-conviction ideas. Plus they'll also be sharing their thoughts on each other's top holdings, too.

Uniti Group (ASX: UWL) 

First up, we have Unity Group. They've made numerous acquisitions over the past 12 months and its share price is up around 95% over the same time period. Chris, it's one of your top holdings. Take us through your reasoning behind it.

Chris Stott (BUY): We're quite attracted to the management team - Michael Simmons, Vaughan Bowen - who have been there and done that before; some of the best performing Telco entrepreneurs in the last 10 years. Really strong balance sheet, ASX 200 inclusion coming, we think over the next few weeks. So, it's a buy for us over the medium to longer term.

Ally Selby: Marcus, do you think it's a buy, hold, or sell?

Marcus Burns (SELL): Look, I'm going to take the other side of that and say it's a sell. The key thing for us is we see some risks around the balance sheet. They have done a lot of acquisitions to Chris's point, but it's carrying a tonne of goodwill and we think there's some long-term potential margin risk.

Supply Network (ASX: SNL) 

Ally Selby: Next up, we have Supply Network, which is one of your top holdings, Marcus. It sells parts for trucks and buses. Take us through what attracted you to that stock.

Marcus Burns (BUY): Sure. It's been a long-term organic rollout story. So they supply, as you said, bus and truck parts. They're one of the leading aftermarket suppliers in Australia. If you look at the last 10 years, they've probably grown revenue, something like 10, 11, 12% CAGR over that period of time. And they've grown EBIT around 20% per annum on average, over that period of time. It's an incredible story of success, very high return on capital. And yet we still think the valuation's pretty supportive of the long-term story there. So we like that a lot.

Ally Selby: Chris, do you think it's a buy, hold, or sell?

Chris Stott (HOLD): Hold for us. It's in a bit of a sweet spot at the moment, in a truck, car part market. Red hot at the moment. But it's a hold for us. Liquidity in the stock's a bit tricky for us, too. So hold.

Capitol Health (ASX: CAJ) 

Ally Selby: Okay. Next up we have one of your largest holdings, it's Capitol Health, it's a diagnostic imaging provider. Why did you buy that stock?

Chris Stott (BUY): The radiology market remains incredibly strong. Over the last six to 12 months we've seen that in the Medicare data. A new CEO's come in, cleaned up the business, net cash balance sheet, ripe for acquisitions, capital management. So we think that it's a buy over the medium to longer-term from here.

Ally Selby: Marcus, its share price is up 81% over the past year. Do you think it's a buy, hold, or sell?

Marcus Burns (HOLD): I think it's a sound business to Chris' point. Good cash flow conversion, I guess we would be a hold. Mainly the reason there is that the valuation's pretty full around these levels.

Class (ASX: CL1)

Ally Selby: Next up we have another of your top holdings, it's Class. What attracted you to that stock?

Marcus Burns (BUY): So Class has a number of attractions for us. It's got an incredible business and is taking market share in the SMSF accounting space. It's launched a couple of products recently in Class Trust. It was also consolidating to technology around document preparation software. So, great retention of its clients, something like 99.3% of its client base is retained every year, very cash generative and a very supportive valuation. So we are really, really attracted to Class.

Ally Selby: Chris, over to you, is Class a buy, hold, or sell?

Chris Stott (HOLD): Hold for us. So we think Andrew Russell's a really good operator and he's come in cleaning the business up. We temper our view a bit at the moment in terms of the increased capitalization of costs. $18 million been spent this year to catch up for the last few years of underinvestment. So that tempers our view in terms of that stock for now. So it's a hold.

PSC Insurance Group (ASX: PSI) 

Ally Selby: We're staying on you, now. We have PSC Insurance, another of your top holdings. It's up around 44% over the past year. What is your thesis behind that stock?

Chris Stott (BUY): It's the number three insurance broking business behind OzBrokers and Steadfast here domestically. A-grade management team again, with really good skin in the game. The premium rate environment continues to tighten and provide a good outlook for not only domestically, but also they're a growing business over in the UK. So we think it's a buy.

Ally Selby: Marcus, what's your stance on this company?

Marcus Burns (BUY): We would probably be a buy. It has good cash generation, good growth, and yet can also bolt-on some organic opportunities as well. So not bad. And you know, it's fully priced, but probably quite a good long-term outlook there as well.

NZME. (ASX: NZM)

Ally Selby: Last up we have NZME. A media and entertainment company based in New Zealand. Tell us a little bit about this company.

Marcus Burns (BUY): So NZME, it owns the leading radio stations in New Zealand. It's one of the leading newspaper companies in New Zealand. Again, most people would look at that and say, "Well, why would you be attracted to that?" But it's in the process of digitising its subscriber base. So 1.7 million-odd readers daily, only monetizing about 50,000 of those currently. So there's a lot of users that can eventually convert to paying subscribers, which we think is attractive. It's rapidly de-geared the business. So small net-debt, very cash generative right now, and incredibly cheap. So we think it's a really good long-term story from here.

Ally Selby: Chris, do you agree? Do you think NZME is a buy?

Chris Stott (HOLD): Hold. So we temper our view there based on the lack of earnings growth for that company over the next few years, but certainly, they are in a good position and generate good levels of cash, as Marcus mentioned there. So we're a hold for now.

Ally Selby: Well, that's all we have time for today. We hope you enjoyed this analysis of Chris and Marcus' top holdings. If you did, why not give this episode a 'like'. Remember to subscribe to our YouTube channel so you never miss an update.